When the Mispricing is Right

Written by Scot Blythe on Wednesday, August 23rd, 2017 at 1:16 pm

Real alpha opportunities — based on consistently harvestable mispricings rather than a manager’s hard-to-replicate intuition — can be difficult to find. Certainly the pages of the financial press are littered with tales of hedge fund managers whose hot hands have now gone cold.

But there does seem to be some method — and returns — in the event-driven space. “The value proposition of event-driven is a powerful one for those who are interested in moving along the efficient frontier, in that it offers the potential for alpha as well as being lower correlated with other asset classes,” says Arvind Navaratnam, a portfolio manager at Fidelity Investments.

In particular, he points to “attempts to take advantage of corporate actions, such as spinoffs, companies going through bankruptcy processes and other types of special situations. And often in these types of events, there’s forced selling pressure, limited research coverage and other market inefficiencies that a disciplined, patient and opportunistic investor can take advantage of.”

One stream of opportunities flows from the index-following bias of asset managers, which often overrides fundamental research. When indices are reconstituted, some assets can be had cheaply.

“The key thing is that there is a human behaviour driving the potential for mispricing behind all of this,” explains Navaratnam. “Over $2 trillion today is indexed to the S&P 500, and so when Facebook was added to the S&P 500 a couple of years ago, $2 trillion was forced to buy Facebook without regard for the intrinsic value of that business and, similarly, when a business is removed from an index such as the S&P 500 without regard for the intrinsic value of the business.”

Hedge fund managers often short stocks, which is a negatively asymmetric payoff (one can only double one’s money if right but lose multiples of money if wrong). It’s a bet Navaratnam refuses to take. Instead, he says, “we focus only on those types of corporate actions where there’s forced selling pressure. What we found is that these corporate actions offer the potential to dramatically outperform the market over long periods of time.”

He notes that companies that are subject to corporate actions, such as spinoffs, “behave very differently from the rest of the market, to the tune of the alpha stream being about one-fifth as correlated as other funds.”

Spinoffs have another characteristic beyond forced selling, Navaratnam points out, one that is important to understanding mispricing — or rather, investors’ low expectations. As an example, he cites the spinoff of Phillips 66 from ConocoPhillips in 2012.

“What’s interesting about spinoffs is that there’s this forced selling pressure. Also, in the case of ConocoPhillips, you have entrepreneurs who were part of a division of Conoco that could go after cost-cutting opportunities and growth opportunities that they couldn’t before because they are driving the shift.”

At the same time, Navaratnam minimizes the downside stemming from the intervention of other market actors. “Investors can’t take the risk that the company announces it’s going to be spun off and then private equity buys it out,” he says. “Rather, investors need to get involved post-event — it’s less risky and offers meaningful outperformance.”